401(k) contributions are deducted from your paycheck before taxes are taken out. This makes them exempt from federal income taxes, as well as state income taxes in most cases. Therefore, you contribute to your account with pre-tax dollars and only pay taxes on the money when you withdraw it in retirement. This can result in significant tax savings over time, especially if you’re in a high tax bracket. However, it’s important to note that you will pay taxes on the earnings when you withdraw them during retirement, so it’s important to plan for this accordingly.
401k Tax Exemptions
401(k) plans offer significant tax advantages, allowing participants to save for retirement on a tax-deferred basis. Contributions to a 401(k) plan are made pre-tax, which means they are deducted from your paycheck before federal income tax and FICA taxes are calculated. This reduces your current taxable income, potentially saving you money on your annual tax bill.
Federal Income Tax
Contributions to a traditional 401(k) plan are exempt from federal income tax. This means that the money you contribute to your 401(k) plan is not taxed until you withdraw it in retirement, potentially many years later. Withdrawals from a traditional 401(k) plan are taxed as ordinary income, but the tax rate you pay may be lower than the rate you would have paid when you made the contributions.
Roth 401(k) plans offer a different tax treatment. Contributions to a Roth 401(k) plan are made after-tax, which means they are not deducted from your paycheck before taxes are calculated. However, withdrawals from a Roth 401(k) plan are tax-free, including earnings, if certain requirements are met. These requirements include:
- You must be at least age 59½ at the time of withdrawal.
- The funds must have been in the Roth 401(k) plan for at least five years.
| Type of 401(k) Plan | Contributions | Withdrawals |
|---|---|---|
| Traditional 401(k) | Exempt from federal income tax | Taxed as ordinary income upon withdrawal |
| Roth 401(k) | Made after-tax | Tax-free upon withdrawal if certain requirements are met |
State Income Tax
401(k) contributions are generally exempt from state income tax. This means that you will not have to pay taxes on the money you contribute to your 401(k) account. However, there are a few exceptions to this rule. For example, some states may tax 401(k) withdrawals that are made before the age of 59½. Additionally, some states may tax 401(k) loans that are not repaid on time.
The following table lists the states that do not tax 401(k) contributions:
| State | 401(k) Contributions Taxed? |
|---|---|
| Alabama | No |
| Alaska | No |
| Arizona | No |
| Arkansas | No |
| California | No |
| Colorado | No |
| Connecticut | No |
| Delaware | No |
| Florida | No |
| Georgia | No |
| Hawaii | No |
| Idaho | No |
| Illinois | No |
| Indiana | No |
| Iowa | No |
| Kansas | No |
| Kentucky | No |
| Louisiana | No |
| Maine | No |
| Maryland | No |
| Massachusetts | No |
| Michigan | No |
| Minnesota | No |
| Mississippi | No |
| Missouri | No |
| Montana | No |
| Nebraska | No |
| Nevada | No |
| New Hampshire | No |
| New Jersey | No |
| New Mexico | No |
| New York | No |
| North Carolina | No |
| North Dakota | No |
| Ohio | No |
| Oklahoma | No |
| Oregon | No |
| Pennsylvania | No |
| Rhode Island | No |
| South Carolina | No |
| South Dakota | No |
| Tennessee | No |
| Texas | No |
| Utah | No |
| Vermont | No |
| Virginia | No |
| Washington | No |
| West Virginia | No |
| Wisconsin | No |
| Wyoming | No |
FICA Taxes
FICA (Federal Insurance Contributions Act) taxes are a combination of two payroll taxes: Social Security tax and Medicare tax. These taxes are used to fund the Social Security and Medicare programs, which provide retirement, disability, and health insurance benefits.
- Social Security tax is a 6.2% tax on wages up to the Social Security wage base, which is $147,000 in 2023. This means that the maximum amount of Social Security tax that you can pay in 2023 is $9,114.
- Medicare tax is a 1.45% tax on all wages. This means that there is no wage limit for Medicare tax.
Both Social Security tax and Medicare tax are withheld from your paycheck by your employer. These taxes are then paid to the Internal Revenue Service (IRS).
401(k) contributions are made on a pre-tax basis. This means that they are deducted from your paycheck before FICA taxes are calculated. As a result, 401(k) contributions reduce your taxable income and the amount of FICA taxes that you pay.
For example, if you earn $100,000 per year and contribute $10,000 to your 401(k), your taxable income will be reduced to $90,000. This will save you $620 in FICA taxes ($9,114 x 6.2%).
401k Tax Exemptions
401(k) plans offer tax advantages that can help you save for retirement. One of the most significant benefits is that 401(k) contributions are made on a pre-tax basis, meaning they are deducted from your paycheck before taxes are calculated.
Capital Gains Tax
Capital gains tax is a tax on the profit you make when you sell an asset, such as a stock or bond. The amount of tax you pay depends on how long you held the asset before selling it. If you hold the asset for less than one year, you will pay short-term capital gains tax rates, which are the same as your ordinary income tax rate.
However, if you hold the asset for more than one year, you will pay long-term capital gains tax rates, which are lower than short-term rates. Long-term capital gains tax rates are 0%, 15%, or 20%, depending on your taxable income.
401(k) plans offer a unique advantage with respect to capital gains tax. When you sell an asset in your 401(k) plan, the capital gains are not taxed until you withdraw the money from the plan.
This can provide a significant tax savings, especially if you are in a high tax bracket when you retire. For example, if you are in the 25% tax bracket when you retire, you will pay 25% capital gains tax on the money you withdraw from your 401(k) plan.
However, if you held the assets in your 401(k) plan for more than one year, you would only pay 15% capital gains tax.
Additional 401(k) Tax Exemptions
- Federal income tax
- State income tax (in most cases)
- Social Security tax
- Medicare tax
| Tax | Exemption |
|---|---|
| Federal income tax | Yes |
| State income tax | Yes (in most cases) |
| Social Security tax | Yes |
| Medicare tax | Yes |